South Carolina Lawyer
SC Lawyer, March 2009, #1.
Representing a Buyer in an Uncertain Economy: Mitigating the Risk
South Carolina LawyerMarch 2009Representing a Buyer in an Uncertain Economy: Mitigating the RiskBy Melinda Davis LuxIntroduction
Both the current uncertainty in the economy and the tightening in the credit markets have caused a slowdown in recent merger and acquisition activity. The deterioration of the economy, however, has created a buyer's market. Buyers with cash or available financing have the opportunity to purchase businesses at favorable valuations. In addition, seller financing is more likely to be available in today's economy.
Buying a business in the current economic climate, however, is generally riskier than buying a business when the economy is stable and healthy. Transactional attorneys who represent buyers should advise their clients of the heightened risks presented by the current economic climate and suggest strategies for lessening those risks. This article describes some of those risks and strategies.
This article assumes that the seller has not filed for bankruptcy protection and is not conducting an auction. In addition, this article addresses risks and strategies that apply generally to most business acquisitions and does not address risks that are industry specific. In this article, references to "seller" usually refer to a seller of assets. If the transaction is a stock purchase or a merger, references to the "seller" should generally be read to refer to the target company.
Investigate the seller's accounts receivable
During a downturn in the economy, some of the seller's customers may be facing cash flow and other financial challenges. As part of its due diligence, the buyer should pay particular attention to the seller's accounts receivable, reserve for doubtful accounts and historical collection data.
The buyer's due diligence review may reveal that some of the seller's customers are slowing their payments. If that is the case, the seller may collect fewer of its accounts receivable than it has in the past. The seller may or may not have created a reserve for doubtful accounts that, in the buyer's view, adequately addresses this risk.
If the buyer is purchasing accounts receivable, the purchase price includes a value for those accounts receivable. The buyer should view the value of the accounts receivable on the seller's balance sheet with skepticism. To address collection risk, buyers often apply a discount to accounts receivable, with old accounts typically discounted more than new accounts. In the current economic climate, a buyer should generally apply a greater discount to the seller's accounts receivable. The buyer may also heavily discount specific accounts, and may be unwilling to pay for some accounts. If the buyer and the seller disagree about the collectibility of particular accounts, one solution is to exclude those accounts from the purchase.
Even if the buyer is not purchasing accounts receivable, the buyer should carefully analyze the seller's historical collection data. Buyers commonly value a business by taking the average annual earnings of the business over a period of time and applying a multiple. Using a historical approach to value a business is risky when the economy is deteriorating. If some of the seller's customers are experiencing financial stress, future revenues from those customers are uncertain. Those revenues may not be replaced in the short term. The buyer should lower its valuation of the seller's business, and consequently the purchase price, to reflect the potential loss of those revenues.